ASC 842 | "Lease Accounting Standard for Leases" | Finance Facts

On February 25, 2016, FASB issued Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). ASC 842, also known as the "Lease Accounting Standard for Leases," is a collection of accounting rules issued by the Financial Accounting Standards Board (FASB) in the United States that involve all entities that report under Generally Accepted Accounting Principles (GAAP).

ASC 842 significantly changed the way leases are accounted for on financial statements. Under the old rules, most leases were categorised as operating or capital leases. Operating leases were not reported on the balance sheet. In contrast, capital leases were treated similarly to asset purchases and reported on the balance sheet.

ASC 842's effective date depends on the type of business:

Public Companies:

  • ASC 842 was effective for reporting periods beginning after December 15, 2018, for public companies and non-profit organisations. This means public companies adopted the standard on January 1, 2019.

Private Companies:

  • The effective date was delayed due to the COVID-19 pandemic for private companies and private non-profit organisations. It became effective for annual reporting periods beginning after December 15, 2021. For calendar-year companies, this meant adopting the standard on January 1, 2022.

So, the result of ASC 842 started being felt by public companies as early as 2019, while private companies adopted it more recently, at the beginning of 2022.

It's important to note that some entities (like non-profit organisations) have additional provisions and extensions depending on their specific circumstances.

Under ASC 842, all leases are classified as finance leases and reported on the balance sheet. This means businesses must now recognise a lease liability on the balance sheet for the present value of the minimum lease payments over the lease term. They must also identify a right-of-use asset for the same amount. 

While ASC 842 significantly broadened the scope of lease accounting, it does provide a few key exceptions:

1. Short-Term Leases (12 Months or Less):

  • Lessees can elect not to apply ASC 842 to leases with a term of 12 months or less as long as they don't contain a purchase option that the lessee is reasonably sure to exercise.

  • Instead, these leases can be accounted for using traditional operating lease accounting, recognising lease payments as an expense on a straight-line basis over the lease term.

3. Leases of Intangible Assets:

  • Leases solely granting the right to use intangible assets, such as software, trademarks, or patents, are expressly excluded from ASC 842.

  • These leases are typically accounted for under other accounting guidance, such as ASC 350 for intangible assets.

4. Leases of Inventory:

  • Leases, where the underlying asset is considered inventory to the lessor (e.g., leased automobiles to a car dealership), are also exempt from ASC 842.

  • These leases are usually accounted for under ASC 606, Revenue from Contracts with Customers.

5. Subleases:

  • While ASC 842 applies to subleases, lessees can elect not to separate non-lease components from subleases of assets considered investment property under ASC 360.

  • This exemption simplifies accounting for subleases of properties like real estate.

6. Land Easements:

  • A practical expedient allows entities to account for land easements as intangible assets outside the scope of ASC 842, as long as specific criteria are met, such as the right-of-use asset relating to land only and not involving any other assets.

7. Licensing Arrangements:

  • Arrangements that grant rights to use intellectual property or other assets but do not transfer control of the underlying asset are typically not considered leases under ASC 842.

  • These arrangements are often accounted for under other guidance, such as ASC 606 for revenue recognition.

8. Leveraged Lease Arrangements:

  • ASC 842 retains the specialised accounting for leveraged leases, which involve a lessor acquiring the asset using a significant amount of non-recourse debt.

  • These leases continue to be accounted for under previous guidance, with complex rules for recognising income and expenses.

This change brings both challenges and opportunities:

Challenges:

  • Increased Balance Sheet Size: All operating leases, previously hidden in footnotes, now add liabilities and corresponding assets, inflating the balance sheet and potentially impacting financial metrics like debt-to-equity ratios.

  • Implementation Costs: Transitioning to the new standard involves identifying and classifying leases, calculating present values, and updating accounting systems, generating substantial initial costs.

  • Increased Volatility in Earnings: Recognising lease expenses upfront instead of over the lease term can lead to increased volatility in reported earnings, particularly for companies with significant leasing activities.

  • Complex Calculations: Accurately determining lease terms, discount rates, and option values can be tricky, requiring specialised skills and potentially external consultants.

Opportunities:

  • Enhanced Transparency: Investors and creditors gain a clearer picture of a company's total lease obligations, improving overall financial transparency and potentially making comparisons across companies easier.

  • Informed Decision-Making: Recognising lease expenses upfront promotes a better understanding of the cost of leasing versus buying, aiding informed decisions about asset acquisition strategies.

  • Improved Risk Management: Increased visibility into lease commitments allows for better risk management by proactively planning for future lease payments and optimising lease portfolios.

  • Potential Tax Benefits: The new standard can sometimes lead to tax benefits by accelerating depreciation deductions for right-of-use assets.

Additionally, consider these points:

  • Different entities experience varying effects: Public and larger private companies face more significant implementation challenges than smaller entities.

  • Industry impact varies: Businesses in lease-intensive industries like airlines, retail, and manufacturing are typically more affected than those with minimal leasing activities.

  • Flexibility in implementation: The standard offers some practical expedients and election options that entities can leverage to simplify implementation.

Overall, the impact of ASC 842 varies depending on the specific business and its reliance on leasing. While it presents challenges like increased workload and potentially negative financial metrics initially, it also offers opportunities for improved transparency, informed decision-making, and better risk management in the long run. 

Suppose you want to bypass ASC 842, finance rather than lease equipment or apply for working capital. In certain situations where compliance is readily available, or if the funder offers impressive concessions that more than compensate accounting fees, leasing may be the appropriate way forward.

Remember:

  • Carefully evaluate each arrangement to determine whether it meets the lease definition under ASC 842 and qualifies for applicable exceptions.

  • Consult with accounting professionals for guidance on specific scenarios to ensure the accuracy of the regulation application.

Here are some additional resources that you may find helpful:

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Commercial Finance Now does not provide tax, legal or accounting advice. This post has been drafted for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your tax, legal and accounting advisors before considering any tax treatments.